There has been much speculation going on in recent weeks about the state of the Italian economy. Italy’s 10-year bond yield now sits at around 3,5%, after having reached highs a couple weeks ago of almost 4%.
The Italian stock market has been following a similar trend, falling by over 500 points since May 2018.
If things do not change, Italy will surely need to be rescued by the Troika,( The ECB and the IMF) This situation, is somewhat reminiscent of what happened with Greece a few years ago. But Italy is not Greece and the Italians may have some other surprise is store of Europe.
Just like the Greek people, the Italian’s feel like they have been ruled by the Troika since they joined the eurozone. After almost two decades of doing things the Troika’s way, with disastrous economic results, the Italians voted for a new path in March. As Deputy Prime Minister Matteo Salvini put it, “Years of budgets imposed by Europe have made our public debt explode… finally we are changing course and betting on the future and on growth.”
This new path will bring about a default and departure from the euro because it is not compatible with the euro and EU. Italy is not walking in Greece’s footsteps. It is on a different path, though they share the same destination: default and a departure from the euro. Delivering the biggest financial crisis in history.
Italy’s political crisis.
The Italian government finally approved the “Note of updates to the budget” for the upcoming years 2019-2021. The new proposal is for a deficit of 2.4% for the next three years.
The next day, the Italian stock market lost more than 3.7%. At one point it was down 4%. Italian bank stocks lost at least 8%. Some crashed so far they had to stop trading.
Why did this happen? Is it the beginning of another global crisis?
The current government was formed in June after several months without one. The electoral results required a coalition to form.
The new government was eventually formed by two parties which are completely different from one another.
One the one hand, we have the Five Star Movement, a very socialist party. While on the other hand, we have the League, a center-right party which is much more liberal in its economic policy.
If you compare the new budget forecasts with the former forecasts, it becomes clear. The commitments of the previous Italian government foresaw a deficit of 1.6% in 2018, of 0.8% in 2019, of 0% in 2020, and a surplus of 0.2% in 2021. The difference to the new proposal, which promises a deficit of 2.4% each year, is thus 0.6% in 2019, 2.4% in 2020, and 2.6% in 2021.
Herein lies the reason behind the fall in the stock market and increase in bond yields.
Italy’s debt problems
Higher interest rates, especially if permanent, obviously affect the new debt being issued by the government.
But higher interest rates on public debt will also mean higher interest rates on private loans too. That’s because Italian banks use the Italian government ten-year bond yield as reference rate. When Italian government bond yields spike, this increases debt costs for Italian businesses too. And that affects any private investment which comes from bank loans.
That’s why the Italian GDP in the period 2011-2013 sank, and why it recovered in the last two years. Interest rates on Italian debt affected the whole economy. The volatility in the Italian government bond market is directly linked to the rest of the Italian economy.
Like any other country, Italy is subject to the rating agencies. If Italian bonds become rated “junk” they will lose all access to ECB credit.
Rating agencies are fearful of what the socialist part of the Italian government might do.
We will see in a few weeks who will win this battle. If the populist part of the government becomes dominant, then the rating agencies will downgrade the Italian public debt to junk.
Italy and Brexit
Understanding the Italian political situation is easy with reference to Brexit. And when you put the two together, we begin to see what’s really happening.
The trouble with party politics is that it doesn’t hold up well when it really matters. On some issues, parties are split down the middle and politicians are willing to betray their party or even their voters. That is the nature of the issue in Italy and in Britain at the moment.
First, let’s take Brexit. When you have two policy options and two political parties, you have four possible groups.
There are Conservative Remainers and Brexiteers. There are Labour Remainers and Brexiteers. The result is a quagmire because none of the four groups has enough of a majority to govern.
Italy’s situation is almost the same. The policy choice is to escape the EU and eurozone, or remain inside. But there are three groups fighting it out. The EU (including the institutions backing it, like the IMF and ECB) and Italy’s two governing political parties.
Just as over Brexit, each of these groups is divided between those who think Italy should be freed from the EU and eurozone, and those who think it should remain tied to the euro and the EU. Some favour a half-in, half-out approach, as on Brexit. The result is the same political stalemate.
There are plenty of other parallels with Brexit too. Especially when you get into the considerations that should determine the best outcome. Nobody can agree on economic forecasts for the various options. And political sovereignty is a major issue. The EU will get a chance to reject Italy’s budget before the Italian parliament gets a vote on it, for example.
Once you realise how similar the situation is between Brexit and Italy, it becomes much more clear what is going on. The EU’s Brexit negotiation strategy is driven by matters in Greece and Italy, not Britain. If Brexit is a success, there are simply too many nations that would immediately seek to follow. It’s difficult to understand the EU’s hostility towards Britain until you realise its eye is on southern Europe.
In May, the Italian president rejected the initial pick for finance minister. He wanted a more pro-EU candidate. And he got one in Giovanni Tria. Tria did his job, pushing for compliance with EU rules in the budget. Until the last minute, he reassured the world that Italy would compromise.
But on Thursday night, the Lega and Five Star leaders just announced their own budget. The finance minister was completely sidelined. He’s since reluctantly mumbled support and promised the new budget would deliver growth, something I doubt he believes.
The next line of defence is the one that worked last time around. The president who vetoed the eurosceptic finance minister is now threatening to veto the budget.
The EU is running out of ammo. Next, come the big guns in the form of the EU Commission and their ability to reject the Italian budget. The due date for Italy to submit to the EU is 15 October. But don’t forget the possibility of leaks and PR stunts in the meantime. Markets will price in what they expect to happen.
But could the Italians really leave the EU and eurozone? For now, the leaders of the two governing Italian political parties are declaring their intention to change the EU from within.
However, each party has a significant amount of anti-euro politicians. Just as Theresa May is being pressured to abandon Chequers, Italy’s governing parties could be pressured to abandon the euro.
The question is whether the parties split. And down which lines? Will the coalition government break up, leading to new elections? Will the eurosceptics take over their parties, just one of the two major parties, or split up the parties themselves?
The problems in Italy will surely affect us all over Europe. Most notably, this could come in the form of a banking crisis. Obviously, it is the banks which hold government debt.
The interesting thing is that while Italian banks started dumping their holdings of Italian bonds a few months back, they have begun to buy them back in recent weeks.
This is probably due to political pressure to support the price of the bonds.
However, if the Italian government defaults, the Italian banks will be in huge trouble. And this banking crisis could quickly spread to the rest of the banks in Europe, creating a full-blown European financial crisis.